I had the pleasure of working on a new OECD working paper highlighting the increasing use of the terms “normal” and “excess” returns in tax policy analyses with my former colleague, Hayley Reynolds, Director (Economist) of Corporate Income Taxation at the National Treasury of South Africa.

Let me start by saying I have never heard a businessperson mention “normal” returns. Businesses are failures if they earn a government bond rate that any passive investor can earn by clipping coupons. Businesses talk about requiring minimum “hurdle rates” for their investments that reflect corporate financing and the many risks they manage, which are considerably higher than a government bond rate.

“Excess” returns are often suggested as location-specific rents which could be taxed at very high rates, since many analysts think businesses do not respond to taxes on economic rents. In contrast, many analysts argue that “normal” returns should not be taxed to eliminate the tax on real investment and savings. Conceptually, the distinction between “normal” and “excess” returns could matter for more efficient tax policies.

Unfortunately, academics and other policy analysts haven’t defined these two terms before policymakers have started enacting the concepts in tax legislation. The Allowance for Corporate Equity (ACE) is an example where the “normal” return in actual tax law ranges from half of the “risk-free” government bond rate to the government bond rate plus 3 percentage points. The European Commission’s new CCCTB proposal includes an Allowance for Equity and Investment, which will set the ACE at the 10-year government bond rate plus an unspecified risk premium. Since hurdle rates differ by type of company, industry and country, practically implementing differential taxation of "normal" and "excess" returns will cause its own distortions.

The issue arises in natural resource “rent” taxes and also in cash-flow taxes where tax loss carryforwards require adjustment for an interest factor to achieve the claimed efficiency effects. The House Ways and Means Republican’s Tax Reform Blueprint says tax loss carryforwards under its cash-flow tax will be adjusted by an interest factor that compensates for inflation and a real return to capital, but without specifying the return to capital. Too low a rate means there is still tax on marginal investments, while too high a rate provides a windfall subsidy.

Taxing rents on an origin basis makes a country less attractive to invest in since the average effective tax rate increases relative to the after-tax return on comparable investments in other countries, as noted by Devereux and Griffith (1998). If “normal” returns are as low as current government bond rates, does it really matter that they are taxed or not taxed, since businesses focus on earning “economic profits”?

The OECD Working Paper notes that many economic analyses and even tax policies are being done without a careful consideration of the terms being used. Tax policy design will never be perfect since policymakers and analysts must weigh trade-offs between efficiency, effectiveness and simplicity, but designing good tax policy is not helped by fuzzy terminology. A clear consensus on conceptual terms, such as “normal” and “excess” returns, will strengthen future analyses and enable better modeling of their effects.